When you read hype, it sounds like something is about to take over the world. Read an article on artificial intelligence in the law and you can be sure that the offices next to you are now occupied by robo-lawyers. In another article, you learn about blockchain technology. By the time you are done reading, you fear that if you haven’t mastered blockchain by the end of the day, your legal career is over. The art of hype has taken to new levels the ability to scare the bejeezus out of those being hyped.
Unfortunately, hype has a dark side that we all experience. If you do think there is something to artificial intelligence, blockchains, or any other development, hype is sure to set expectations so high that reality cannot reasonably reach them. When those scared into learning more dig into the facts they find that the real world pales in comparison. Over-hype a good thing and you can send something down the path to obscurity before it reaches its potential. Value fees almost became one of those victims.
Value Should Be at the Heart of What We Do
Value fees (alternative fees, appropriate fees, etc.) came close to never reaching its potential. Apart from the head of finance at a major law firm, it is hard to find anyone who really likes the billable hour. Everyone knows its evils, but few sing its virtues (we all know there is a reason for that, but some valiantly try to squeeze out a few notes). Value fees were hyped far ahead of their time.
The idea of value fees was and is great. It is hard to argue with the basic proposition that the client should pay what it thinks the service is worth and the service provider should receive what it thinks the service is worth. But you may also think, it sounds like there will be a gap. The service provider will go high, the client go low, and they won’t be able to agree on a price.
Ponder this false dilemma a bit more, and you can see what will happen. The service provider will bring down its price. If the client doesn’t come up, the service provider will learn its prices are too high. If the client does come up, the service provider and client can find a point where the value exchange equalizes and they engage in the transaction.
Value fees adjust for risk apportionment. They also adjust for cost, context, point in time, and a myriad of other factors. Value fees are a way of adjusting more than just the pricing, they can adjust the entire value chain for the transaction, and that is far more efficient than having a pricing system based on a measure insensitive to the concerns I listed above (I’m looking at you, billable hour).
What is Value?
We have just hit the point where many lawyers—law firm and client—drop out of the value fee discussion. These fees require something that has been bred out of most lawyers, and that is the ability to understand how they provide services. Without the knowledge of how services are provided, lawyers find it almost impossible to make value fees work consistently. They see this as value fees being over-hyped and stop using them.
To understand this cycle, we need to explore the concept of value fees more deeply. First, we need to get past the stumbling block for all lawyers. Say “value fee” and the first question you get is “how do we determine the value.” A simple answer usually is best, especially when it is accurate: the “value” of a service at a point in time is whatever the client and service provider can agree on as a price. Second, we must recognize that the billable hour has nothing to do with value. It is a measure of inefficiency—the greater the invoice the more inefficient the process (though not necessarily the service provider).
Most people get, even if they struggle with, the part about the value being what the client and service provider agree upon. They have experience with these types of transactions. When you buy a car, a house, a pair of shoes, or a dinner at a restaurant, the value of whatever you buy is what you are willing to pay the other party.
The other part of the definition—at a point in time— throws many lawyers. The value of the exact same service can vary from time to time. In fact, lawyers also are familiar with this phenomena even though most don’t know it.
Want to buy a book from a well-known online retailer? You go on its site and check out the book, but you can’t make up your mind. The book costs $19.95 and you aren’t sure you want to pay that much for it. A few hours later, you are surfing the web when an ad from that same retailer pops up on a site you are visiting. The ad features the book you wanted, except the price is $18.95. You think “wow, a deal” click on the ad and buy the book.
The retailer’s service is selling you the book, but the retailer couldn’t close the deal at $19.95. The retailer was at $19.95 as its value point, but you were at something less. Based on experience selling millions of books, the retailer decided that dropping the price by one dollar would do the trick. So, it offered the same service at a lower value, $18.95. You agreed, and the transaction went through.
What you did not know, is that when you were buying the book for $18.95, the retailer was selling another copy for $19.95 and another for $19.25. Each time, the service was the same—selling a book and delivering it to the customer (assume that cost of delivery was the same in each instance). But, three different values were placed on the transaction, based on what the service provider was willing to accept and the customer was willing to pay. There wasn’t a “right” value for the service.
A ride-sharing service has become famous (or infamous) for understanding that value varies based on context. Hail a ride on a warm sunny day, and you will be charged $X for that two mile ride. Hail a ride from the exact same location on a day when it is cold and rainy, and the cost will be $X+Y for the same trip. Demand for rides has increased so what you the customer are willing to pay has increased, because the ride has greater value to you (staying out of the cold rain versus staying out of the warm sun).
There isn’t one “value” for a service. There are many values, each dependent on many factors. But if trying to find a value to charge (or pay) for a service is difficult, then how can the parties choose among the many values? A large part of the answer lies in that area lawyers don’t understand—how they provide their services.
If You Don’t Know Cost, You Don’t Know Value
When you don’t understand how you provide your services, you don’t understand your cost structure, and without understanding your cost structure setting a value for your service is the same as being left in the middle of a golf course with a blindfold on and being told to find the golf ball. There is a chance it will happen, but the probability is low.
From the service provider’s side, knowing what you will accept as payment for a service starts with knowing the cost of providing the service. Once you know that cost, other factors come into play that will help you set the value. Assume you know the cost of your services is $20,000 (put aside for the moment how you know that). If you accept $20,000, then you don’t lose or make any money. Now, you can adjust up or down what you will accept for the service, based on other factors.
If the client is a new one who could spend hundreds of thousands of dollars at your firm, you may decide to accept less than $20,000 for the service. If the client is problematic and the risk of payment is high, you may decide to charge $30,000 for the service (keeping in mind, of course, professional responsibility requirements). The $30,000 isn’t an arbitrary value, it includes a profit margin and an amount to cover the risk of non-payment. In each case, the client may agree to your value amount, or disagree and decide to negotiate, or simply go elsewhere. The better you understand your services and the market, the less likely you are to lose the sale.
Now we need to circle back and examine how you knew the cost of your services. Trained in the billable hour, most lawyers assume you determine cost by multiplying the number of hours it will take to provide the service by the cost of each service provider. If it takes the partner 10 hours, and his cost per hour is $250 (even though his billable hour rate is $500), then his cost is $2,500. Do that same step for each service provider, add them up, and you have the cost of the service. Not really.
Every day, each lawyer does things at work that fall into one of four categories: value added, necessary but not value-added, unnecessary and not value-added, and other. We can dispense with “other” quickly. It includes all the things that fill up the day but have nothing directly to do with providing services to clients. Getting coffee, talking to your friends, surfing the web, and so on. Forget about those things.
The other three categories are the ones to focus on. When you say that it costs the firm $250 per hour for that partner, you really mean that it costs $250 for one hour of time spent on some combination of value added, necessary waste, and unnecessary waste. Necessary waste includes those things you must do, but which do not add value. Unnecessary waste includes those things which do not add value and which we can eliminate. Law firms typically do not break time out into those three categories, so they don’t really know the cost of the services they provide. In hour one, the lawyer might provide 45 minutes of value added services, 10 minutes of necessary waste, and 5 minutes of unnecessary waste. But in hour two, it might be 45 minutes of unnecessary waste, 10 minutes of value, and 5 minutes of necessary waste.
We can go back to that partner who spent 10 hours to perform his service. The real question is how many of the 10 hours were wasted? Let’s assume this partner is more efficient than the average lawyer and wastes only 50% of his time. That means that out of the 10 hours, 5 hours were value added and the other 5 hours were waste. Remember there are two types of waste, so one of the 5 hours was waste, but we would not have been able to prevent the waste. The remaining 4 hours of waste truly was waste—it should have been eliminated.
From the firm’s perspective, it cost 5 hours value added work by the partner (at $250 per hour) to provide the service, another 1 hour (again at $250 per hour) to provide waste that they couldn’t remove, and 4 hours (also at $250 per hour) to provide pure waste. What should have cost the firm $1,500 to perform (6 x $250) cost the firm $2,500 to perform. This is what I mean by knowing your cost.
When a market has minimal competition (the good old days in the legal industry), spending too much time to perform a service didn’t hurt a firm. It simply passed the excess cost on to the client. In a competitive market, paying more than necessary to perform a service decreases the potential revenue and profit for a firm. Other firms will reduce their cost, lower their prices, and win the client.
This is where process connects with value fees. The firm that controls its costs—not just the billable hours spent, its true costs—has more flexibility on pricing. It can even reduce prices and make more money than a competitor who doesn’t have control of its costs. The firm controlling its costs can use value fees as a competitive weapon while at the same time giving clients predictable pricing.
Flexibility in pricing is not the same as strategy, though without flexibility you are limited in strategy. Flexibility means you can drop your price below your cost, price at your cost, price over your cost, or charge a premium price, all depending on your pricing strategy. You also can vary pricing depending on the context. In other words, you now control the profitability of your organization. Clients always set the price, but by aggressively reducing costs you can increase your organization’s profitability even when revenue drops.
Lawyers shy away from value fees, claiming they are too complex, require too much work, or that they simply don’t work. Value fees are more complex than billing by the hour and they do require more work. Value fees are for firms that respect their clients and trust them. They are for sophisticated firms that understand pricing legal services should not be an exercise in demonstrating your firm’s inefficiency. They also are for lawyers who believe they should get paid a fair price for what they deliver to clients. For clients, value fees are a better, more nuanced way of making sure they pay for the value they receive, reward superlative service, and recognize when there has been a service shortcoming. For all lawyers, value fees get us off the belief that working 24 hours a day is a good thing.